A look at the pros and cons of each strategy.
You may be one of the few lucky people who have money and want to grow their wealth, but you don’t know where to put that money.
Two possible and often popular avenues are to invest directly in commercial real estate or to invest in mutual funds exposed to the real estate sector. It is important to know what the advantages and disadvantages of each strategy are.
Direct real estate investment refers to the purchase of a physical property which can be land, residential building or commercial property. The idea is to generate income from this property in the form of rental income and/or capital appreciation of the property.
Real estate FCPs mainly invest in listed real estate companies that develop and manage real estate. These are usually more diverse across multiple industries and geographic locations.
The advantages of direct real estate investment
- Investing is easy to understand: it is simply buying a property, maintaining the property, and attempting to sell the property for a higher value and/or earn rental income while you own the property.
- Investing using debt: Buying a property usually involves taking out a bond with a bank, so essentially you’re using the bank’s money to earn a return.
- Real estate can act as an inflation hedge: Generally, property is considered an inflation hedge, as it is generally assumed that the value of the property will appreciate and rents generally increase with inflation.
- Ownership can provide tax benefits in the form of both income tax and capital gains tax benefits. Capital gains tax is imposed at a lower effective rate than income tax or dividend tax. The maximum effective personal capital gains tax rate is 18%. However, if the property is your principal residence, an individual will not pay any tax.
Some disadvantages of buying a property:
- Real estate can be a lot of work: to a certain extent, property is simple, but it requires a lot of work due to the costs involved in maintaining the properties.
- Real estate is expensive and very illiquid: it is often easy to put money into the purchase of a property, but withdrawing money from this same property through resale can sometimes be difficult.
- Difficult to diversify with real estate: location is the key to investing in real estate. One area could rise in value while another could fall, affecting the value of your property portfolio. Diversifying real estate properties requires deep pockets and knowledge not available to the average investor.
- The return on investment is not a certainty: there is always a risk of selling a property at a loss.
Although there are a few advantages to investing in real estate, investing in a real estate unit trust can be beneficial. Here’s why:
- Diversification: you can simply choose a real estate fund as one of the underlying funds for your investment if you wish to have a real estate component in your portfolio. You can further diversify your portfolio as some investments cover various geolocations and industries.
- Fund management: there are experienced fund managers responsible for managing the performance of the chosen fund and delivering good returns.
- Fewer fees: Although there are management fees to consider, if you choose a real estate fund, you won’t have to worry about the costs of maintaining your assets, transaction costs or capital .
- Initial investments do not require large capital and there is no need to ask for a deposit. Minimum investments could start as low as R1,000.
- Increased Liquidity: Buying and selling Trust Units can be done on any business day.
Some of the disadvantages of indirect investing are:
- Share prices are more volatile than real estate prices: Share prices can be very volatile and fluctuate much faster than the real estate process. While volatility can be uncomfortable in the short term, it can be beneficial in the long term if you’re willing to hold the units despite the volatility.
- Unit sales may incur capital gains tax: if you sell a unit for a higher price than when you bought it, you may be subject to capital gains tax.
- Emotional decision making: It’s easy to lose faith in fund managers and make decisions based on emotions. Therefore, it is important to know how to manage your emotions and to pay attention to empirical data on the underlying fund.
There are a few things to consider when deciding whether to invest directly in real estate through a unit trust, real estate, or both. Factors such as cash flow, market volatility, tax effects, liquidity, management and transaction costs. Like any other investment, each of these factors has advantages and disadvantages for direct and indirect real estate investing. It all depends on what you prefer in terms of your time horizon, your investment goals and the level of risk you are willing to take.